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By David Barr

The British pop band Dead or Alive had a massive hit in the mid-1980s with You Spin Me Round (Like a Record) on their Youthquake album. It’s a catchy little number.

On the other side of the pond in the investment world, something else is catching on: renewed investor interest in small-cap stocks. They, too, have been spinning “round, right round” in a long-awaited comeback in sentiment and capital inflows — albeit with a bit of a wobble in August.

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After being flat year to date, the Russell 2000 index was up more than 12 per cent by the end of July. The Russell 2000 tracks approximately 2,000 of the smallest public companies in the U.S. market. In Canada, we have the S&P/TSX smallcap index, which includes 246 companies.

Like all indexes, including the S&P 500, these contain a grab bag of constituents of varying quality and profitability (or lack thereof). Studies show only a small percentage of companies generate the majority of returns over the long run. For example, just 21 companies generated more than 64 per cent of the net wealth in Canada from January 1990 to December 2022.

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Because of the wide dispersion in the quality and profitability of smaller public companies, this sector presents a less efficient opportunity set than the large-cap sector. Hence, investors who passively follow the momo — the current positive momentum — must understand they are also buying a significant portion of companies with no earnings, which potentially increases volatility and capital risk.

Apparent tailwinds abound for experienced stock pickers, too. Now, with rate cuts in Canada and the spectre of a September cut in the U.S., smaller companies — often viewed as cyclical and riskier — are starting to come out of their multi-year slumber.

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In comparison to large and megacap stocks, smaller stocks squarely remain in bargain territory, with the S&P/TSX smallcap index trading at approximately 10 times its forward price-to-earnings compared to nearly 14 times for the S&P/TSX 60. A mean reversion would give them a nice pop.

Furthermore, the change in the interest rate regime will bring welcome relief to the balance sheets of smaller companies, which rely more on floating-rate or shorter-term loans and have been disproportionately oppressed by the fast-rising interest rates and reduced capital inflows of the past several years.

For example, 30 per cent of the debt in Russell 2000 companies is floating rate, compared to only six per cent for companies in the S&P 500.

The attractive valuations of these companies are just too good to pass up. They are pulling the focus of private equity and venture capital firms, which have a record-setting US$2.62 trillion of cash reserves that could be deployed on a giant spending spree.

At just past the halfway mark of the year, there have already been several high-profile acquisitions, including Copperleaf Technologies Inc., Nuvei Corp., Héroux Devtek Inc. and Sleep Country Canada Holdings Inc., among others.

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Current prices have a built-in margin of safety that should appeal to value investors. At the most recent Berkshire Hathaway Inc. annual meeting, Warren Buffett (whose right-hand man and likely successor, Greg Abel, just happens to be Canadian) told attendees:

“We do not feel uncomfortable in any way, shape or form putting our money into Canada. We don’t have any mental blocks about that country. And, of course, there’s a lot of countries we don’t understand at all.”

We agree with Buffett. We have no mental blocks either when it comes to Canadian companies because we continue to see an attractive set-up for them. Even with the recent positive moves, valuations are still very attractive on a relative and absolute basis.

Rather than thinking of small caps as a shorter-term tactical investment, smaller, high-quality companies make excellent long-term additions to a portfolio, providing investors can accept short-term volatility. Given how fast small-cap markets can move, it’s important to have an allocation to the asset class to fully experience the long-term returns of small caps.

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One silver lining of the past couple of tough years is that it has allowed investors to position their portfolios into higher-quality businesses trading at reasonable prices. While Berkshire, due to liquidity constraints, must restrict its shopping in Canada to very large enterprises, domestic investors can take a nimbler approach, which means taking meaningful positions in a hand-picked selection of high-quality smaller companies.

David Barr, CFA, is CEO of PenderFund Capital Management.

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